Even troubled banks are willing to flex their balance sheets for one line of business this year. Deutsche Bank has doubled down on its commitment to private equity firms, with a plan to expand its ranks. It is the latest evidence that leveraged buyouts remain among the most lucrative areas for bankers to play in.
Just look at the fees they generate from leveraged buyouts, or debt-driven acquisitions by private equity firms. Banks have earned more than $10bn a year advising and underwriting transactions for such deals since 2012, including billions of dollars packaging and selling private equity-related debt, according to Dealogic and Refinitiv.
With little more than two weeks of the year left, the fees from underwriting loans for private equity-backed groups could hit the highest level since the financial crisis, Dealogic data show. For Deutsche and its peers, that’s a money tree that needs shaking. But as the fees balloon, Wall Street bankers would do well to consider that more stress in financial markets could see those dollars quickly evaporate.
In some cases they have. Banks such as JPMorgan Chase and Goldman Sachs struggled to offload leveraged loans from their balance sheets earlier this month, and were forced to sell the debt packages to mutual funds and managers of collateralised loan obligation (CLO) funds at substantial discounts. When the banks were finalising their commitments to underwrite the deals earlier in the year, volatility in markets had only re-emerged and the question was whether it would persist. Hindsight, as always, hasn’t been much help.
But what exactly is the risk banks take in backing these highly leveraged takeovers? Having agreed to arrange the financing, they promise companies a particular interest rate on a loan, with flexibility to adjust that a certain amount higher depending on the ultimate demand from investors for the debt. In Wall Street jargon, that leeway is known as the flex.
The banks assume the risk on the loans until they are sold to the likes of mutual funds and CLO managers. But if a higher interest rate fails to entice a buyer, they must sell the loans at a discount. When deep enough, those discounts can saddle banks with losses. Three years ago, lenders including Morgan Stanley and Bank of America took multimillion-dollar hits after the bond market seized up and they failed to raise the financing for buyout debt packages they had committed to.
One deal already looks to have been stymied by the market stress. Deutsche Bank and UBS on Thursday pushed the financing of CVC’s takeover of technology services provider ConvergeOne into 2019.
Just as volatility erupted earlier this year, banks are once again trying to protect themselves by increasing the cap on their flex packages. When Bank of America, Deutsche, Macquarie, Credit Suisse and Barclays this week agreed to back the $4.4bn buyout of travel technology group Travelport, they demanded extra latitude on the flex package to syndicate the still-to-be issued debt, sources said. Travelport’s new owners, Siris Capital and an affiliate of Elliott Management, agreed.
Now deciding on how high the cap for the flex should be is not an exact science. While the Travelport deal shows banks are being more prudent, the mood among bankers and lawyers is that the current nerves could steady next year. What’s happening now is simply a healthy repricing of the market, the argument goes.
But there are reasons to be less sanguine about 2019. Central banks, including the US Federal Reserve, are lifting interest rates just as economists are ratcheting down their forecasts for the global economy. And if there was any doubt about the unease among the ultimate buyers of the loans, data this week from Lipper showed the biggest outflows from loans funds in a decade.
That will increase the pressure on the lucrative private equity machine and the banks that help lubricate it. The buyout model is predicated entirely on how much debt you can foist on a company: a higher cost of capital trims the amount of leverage a company can bear. Private equity funds model their cost of capital based on a worse-case scenario, which includes higher caps on the financing packages from banks. Throw in the rise in Libor and the rising spreads on leveraged loans, and interest rates on loans in some leveraged buyouts of about 10 per cent are not the stuff of fantasy.
And if private equity buyers have less financial firepower, it is something that merger arbitrage funds and retail investors need to consider. The big buyouts that have been considered in recent weeks, such as that for US cyber security software maker Symantec and television ratings provider Nielsen, might ultimately come at lower prices if they happen at all
Banks have a bit of breathing space, given there isn’t a huge pipeline of deals that need to be financed in early 2019. But if the sell-off in equities and credit deepens, it could raise difficult questions about the financing banks have committed for Brookfield’s $13.2bn takeover of Johnson Controls’ power business, or the $5.7bn private equity buyout of Athenahealth by Veritas Capital and Elliott Management.
Financial regulators such as the Lael Brainard at the Fed are right to zero in on the market.
The music in the leveraged loans market has, for the moment, stopped playing. We’re about to see if anyone is left without a seat